Are We Near a Stock Market Top?

Now I’m going to discuss a topic which I normally don’t, but now I think it’s the time. Following the markets and looking at charts have long been a hobby of mine. Note: if you are not familiar with technical analysis, then you may have difficulty understanding my article.

Stock indices appear to be going parabolic. Housing prices in some parts of the country (notable the Northeast and West coast) have exceeded their 2007 highs. The mania is back. With the Dow Jones Industrials closing in on 25,000, now may be time to ask whether the market has gone too far. Just over eight years ago the Dow Jones was under 7,000 and felt like no end in sight. Today we have the exact opposite situation.

As of current, most of the major indices are confirming each other’s highs. The Dow Industrials, S&P 500, and NASDAQ have all made new record highs Friday. The Dow Transports, Dow Utilities, and NYSE Composite are all within striking distance of their all-time records. What I’m watching out for is a non-confirmation between at least two major indices. This will signal potential trouble ahead. But there are no signs of a fractured market yet.

Now let’s turn to market breadth. Below is the percentage of stocks in the S&P 500 (there are 500 stocks in that index, thus the name) that are above their 200 day moving averages. It currently stands around 80 percent. No problems here.

However in the NYSE Composite we DO have a divergence. In mid 2016, 80 percent of NYSE stocks were above their 200 day moving average. Despite the NYSE’s steady appreciation, less NYSE stocks are above their 200 day MA’s than they were a year and a half ago. This a clear divergence.

Let’s review what happened ten years ago. In February 2007, the NYSE was at 9463 and roughly 85% of stocks were above their 200 day MA’s. In July, the NYSE was at 10,238 and roughly 70% of stocks were above their 200 day MA’s. In October, the NYSE topped at 10,387 and just 60% of stocks were above their 200 day MA’s. Finally in December, when the NYSE made a high of 10140 (which was just 247 points below their October high), a mere 44% of stocks were above their 200 day MA’s. So you can see what happens during a topping process.

Another contrarian indicator is the University of Michigan consumer survey of market confidence. While the general public is often correct during the meat of the trend, they are always on the wrong side of the markets during major turning points. Typically when the blue line is around 60 percent, time is ripe for a reversal.

The Dow Theory

More than a century ago, Charles Dow (the founder of the Dow Jones Industrial Average) developed six primary tenets of the stock markets. One of the tenets of the Dow Theory is that all bull markets have three phases. In Phase I, which is the beginning of the bull market, economic conditions are still bad and there are doubts about the young bull market. Many investors see the rally as a selling opportunity. In Phase II, which is the middle phase, the economy shows clear signs of recovery and more and more investors participate and become convinced the worst is over. In Phase III, the final phase, mania and rampant speculation sets in as many believe the good times will last forever. The Elliott Wave Principle (discovered by Ralph Elliott and rediscovered by Robert Prechter) also borrows heavily from the Dow Theory. Under EWP, there are five waves in a motive wave (three waves up and two waves down) and that each wave subdivides into five more waves, and each of those subdivides into five more waves and so on. Below is EWP’s waveform numbering. It also illustrates where smart money typically buys and where dumb money (i.e. the public) buys.

You can clearly see all three phases in the Dow Industrials dating back to the beginning of the bull market in 2009.

But why stop there? You can also see three phases in the Industrials dating all the way back to 1900. Notice that Phase III below, subdivides into those three waves shown above. If I’ve drawn this correctly, then the potential for a drop could be of nightmarish proportions!

Junk Bonds

Last we turn to junk bonds – also euphemistically called “high yield corporate bonds”. With bonds the higher the price, the lower the yields. When investors are confident in the economy they accept a lower yield on junk and when they become fearful of the economy they demand a higher yield. During early 2016, junk was yielding over 10 percent. Now it’s barely 5 percent. Low yields also encourage corporations to issue more debt to finance their projects.

HYG is among the heaviest traded junk bond ETF. Elliott Wave International pointed out that HYG had developed a “Head and Shoulders” pattern, which is a fairly reliable technical pattern that gives a high probability of a reversal ahead. Volume surged when HYG decline in early November. That is another one of the Dow Theory Tenets – volume must confirm trend.

The HYG junk bond index actually correlates very well with the S&P 500 and Dow Industrials indices.

Markets and businesses have thrived on cheap access to credit. This spigot could be closing soon and we could see the return of the financial crisis of ten years ago should junk bond rates soar. That in turn will make corporate borrowing more expensive which will squeeze their earnings and in turn set off a decline in the stock markets. While stocks appear to be going parabolic, the opposite is happening to junk bonds and something is going to give. And we also saw the markets clearly indicating three phases of the bull market. The months of November and December are historically good for the markets, but coming January it may be time to be on high alert. Now if you are already in the market I would suggest staying put until breadth starts breaking down and clear signs of a decline is at hand. But if you are not in, STAY OUT. It’s not worth scalping what may be the last percentage gains of the market. Be patient and there should be plenty of opportunity during the next bottom.

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